Financial Stability Review - September 2011

8/4/2019 Financial Stability Review - September 2011

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Contents

Overview 1

1. The Global Financial Environment 5

Box A: European Bank Stress Tests 19

Box B: The Global Reinsurance Industry 23

2. The Australian Financial System 27

3. Household and Business Balance Sheets 45

Box C: A Closer Look at Housing Loan Arrears 57

4. Developments in the Financial System Architecture 61

FinancialStability

ReviewSEPTEMBER 2011


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The material in this Financial Stability Reviewwas finalised on 22 September 2011.

The Financial Stability Reviewis published semi-annually in March and September.It is available on the Reserve Banks website (www.rba.gov.au).

For Copyright and Disclaimer Notices relating to data on dwelling prices from Australian Property Monitors (APM),

see the Banks website.

Financial Stability Reviewenquiries

Information Department

Telephone: (612) 9551 9830

Facsimile: (612) 9551 8033

E-mail: [email protected]

ISSN 1449-3896 (Print)ISSN 1449-5260 (Online)


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FINANCIAL STABILITY REVIEW | S E P T E M B E R 2 0 1 1 1

Overview

Market concerns about sovereign debt sustainability

in Europe have escalated over the past six months

and spread to a wider range of countries in that

region. Severe market reactions to sovereign credit

risk have impinged on funding markets for euro area

banks; in particular, US dollar funding pressures have

re-emerged in recent months. These funding strains

are compounding the difficulties some of these

banks already faced from weak economic growth. As

a result, a number of euro area banks have become

more reliant on central bank liquidity support.

Spillovers to bank funding markets outside the euro

area have, however, been relatively limited so far.

The sovereign debt problems, together with a

reassessment of European and US growth prospects,

have raised risk aversion, and helped trigger a period

of heightened turbulence in global financial markets

since early August. Associated with this, share prices

of financial institutions have fallen sharply in most

major markets, but particularly in the euro area.

While the latest market strains have not been on

the same scale as 200809, it is difficult to tell at

this stage whether this will be another temporary

bout of market uncertainty, of the kind seen several

times in the past few years, or the beginning of a

more serious market dislocation. Much will depend

on the ability of governments, especially in Europe,

to resolve the sovereign debt problems affecting

some countries.

Compared with the pre-crisis period, the major

banking systems should be better positioned to

cope with a period of renewed market stress. Most

large banks in the major advanced countries have

strengthened their capital and funding positions

over recent years. While banks in Europe are carrying

significant aggregate exposures to debt of the

sovereigns whose creditworthiness has declined,

there is less uncertainty about problem exposures

than there was during the 2008 crisis. This is partly

because sovereign bonds are less complex than

the structured securities that sparked the crisis, and

partly because recent supervisory stress test results

provided detailed data to markets about those

exposures. These differences should help to limit any

contagion effects compared with those seen during

200809.

Most large banks have continued to report profits in

the recent period, though overall returns on equity

remain below pre-crisis averages. Many banks are,

however, still dealing with elevated levels of non-

performing loans, particularly property-related

loans, and their loan-loss provisioning is no longer

declining rapidly from the peaks seen during the

crisis. The difficult macro-financial environment in

the major economies will continue to affect the

outlook for banks asset quality and profitability.

The Australian banking system remains in a relatively

strong condition compared with some overseas. The

recent global market turbulence has contributed

to falls in Australian banks share prices and some

tightening in wholesale funding conditions, but

the overall effect has been modest compared with

the experience in 200809 or with some other

countries currently. The Australian banking system

is considerably better placed to cope with periods

of market strain than it was before the crisis, having


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RESERVE BANK OF AUSTRALIA2

substantially strengthened its liquidity, funding and

capital positions in recent years. Growth in bank

deposits is continuing to outpace growth in credit,

and the major banks are ahead of schedule on their

term wholesale funding plans. Profitability for the

major banks has continued to increase to around

pre-crisis levels, mainly due to further declines in

charges for bad and doubtful debts. However, the

scope for banks domestic balance sheets to expand

is likely to be more limited than in the years preceding

the crisis, given the more cautious approach of the

household and business sectors towards leverage.

Banks and their shareholders may therefore need

to adjust their return expectations to be consistent

with an environment of slower credit growth.

Despite the relatively favourable macroeconomic

environment and low level of unemployment, the

ratio of Australian banks non-performing assets to

total assets remains close to its recent peak, though

it is well below the levels seen in the early 1990s

and those currently experienced in many other

developed countries. Business loans still account

for the bulk of banks non-performing loans, but

there has been some reduction in these recently.

In contrast, the non-performing share of banks

housing loans has drifted higher since late 2010.

The bulk of non-performing housing loans are well

collateralised and therefore not likely to lead to

material losses.

The insurance industry in Australia has coped well

with the elevated levels of claims from the natural

disasters at the start of 2011, assisted by robust

reinsurance arrangements. Profits of these firmsdeclined in the March quarter, but have since

recovered. However, their costs of reinsurance have

risen, and at least some of the increase is already

being passed on to customers.

The household sector in Australia is continuing to

exhibit a more cautious approach to its spending

and borrowing behaviour than prior to the crisis.

The household saving rate increased further over

the past year and debt has continued to grow at arate broadly in line with income growth. This relative

caution may partly be motivated by recent volatility

in households net asset position following a long

period of rapid expansion. Around half of mortgage

borrowers are continuing to make substantial excess

principal repayments, which is improving their

resilience to any change in financial conditions.

Even so, household indebtedness remains quite

high, as does the aggregate debt-servicing ratio,

though both are below their recent peaks. While the

mortgage arrears rate drifted up over the first half

of the year, it nonetheless remains at a low level by

international standards and in absolute terms. The

rise has mainly related to loans taken out prior to

2009, when banks lending standards were weaker;

newer loans are performing well despite the increase

in interest rates over the past couple of years.

The business sector is also experiencing mixed

conditions: mining and related sectors continue

to benefit from the resources boom, while other

sectors, including retail, are facing pressures from

subdued domestic household spending and the

high exchange rate. Sectoral measures of profits and

business confidence have therefore diverged. Having

deleveraged considerably, the business sector is in a

stronger financial position overall than it was several

years ago. Businesses demand for external funding

remains weak. This is partly because the business

sector has been able to finance a larger share of its

investment through internal funding in recent years,

as much of that investment has been concentrated

in sectors such as mining, where profitability has

increased the most.

Regarding financial regulatory issues, nationalauthorities are in the process of deciding how best

to implement the Basel III bank capital and liquidity

reforms. The Australian Prudential Regulation

Authority (APRA) recently published a consultative

document on how it intends to implement the

Basel III capital reforms in Australia. Given that the

Australian banking sector has already substantially

bolstered its capital position in recent years, it is

well placed to meet the new standards. APRA has

therefore proposed a faster timetable for adoption


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of the new global minimum capital standards than

required under the Basel III rules.

Meanwhile, the international regulatory reform

agenda has recently been focused on developing

a policy framework to address the risks posed

by systemically important financial institutions

(SIFIs). Agreement is close to being finalised on a

methodology to identify banks that are systemically

important in a global context, along with the level

and form of additional capital that these institutions

will be required to hold above the Basel III

requirements. Another aspect of this work has been

the development of a set of principles on effective

resolution regimes for SIFIs, which are intended toenhance authorities ability to resolve distressed

SIFIs without disrupting the wider financial system

or exposing taxpayers to losses. There has also been

progress over the past six months on a number

of other international regulatory initiatives,

including the move towards central clearing of

over-the-counter derivatives and developing policy

frameworks to address the risks posed by shadow

banks. Australia continues to be an active participant

in the various international discussions that are

shaping these reforms.

Domestically, the Australian Government recently

introduced legislation into Parliament that would

permit deposit-taking institutions to issue covered

bonds. It has also announced the permanent

arrangements to be put in place for the Financial

Claims Scheme, following a review by the Council

of Financial Regulators (CFR) of how the Scheme

should be configured in a post-crisis environment.More recently, the CFR has been examining a

number of issues related to the regulation and crisis

management arrangements for financial market

infrastructures in Australia. R


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1. The Global Financial Environment

Graph 1.1

l l l l l l l l l l l l l l l l l l l l l0

25

50

75

0

25

50

75

Indicators of Risk

2011

-2

0

2

-2

0

2

Global risk appetite*

VIX Index**

1999

%

2007200319951991

%

Stddev

Stddev

* Credit Suisse Global Risk Appetite Index; 30-day moving average ofstandard deviations from mean

** Implied volatility from equity options on the S&P 500 IndexSources: Bloomberg; Credit Suisse; RBA

Public finances have deteriorated substantially in a

number of advanced economies since the onset of

the financial crisis, particularly in Europe, leading to

growing market concerns about the sustainability

of sovereign debt. Difficulties were initially centred

on Greece, Ireland and Portugal, which all received

international bailout packages during the past

year and a half. But more recently, sovereign debt

concerns have spread to a wider range of countries

in Europe, including the much larger economies of

Italy and Spain. Severe market reactions to sovereign

credit risk have resulted in funding difficulties for

banks in some of these countries and tensions in

broader euro area bank funding markets. Althoughthey are not as pressing as the problems in Europe,

there have also been concerns about unsustainable

public debt dynamics in the United States and Japan.

Risk aversion and volatility in global financial markets

have increased sharply since the start of August

(Graph 1.1). This was triggered by a combination

of factors, including: growing concerns about

the creditworthiness of some large sovereigns

in Europe; concerns about the passage of the

US debt-ceiling increase, followed by Standard &

Poors (S&P) downgrade of the US credit rating;

a weaker economic outlook in the United States

and Europe; and related fears about the effect on

financial systems. Underlying all this, markets seem

to have become increasingly pessimistic about the

ability of policymakers to resolve the situation, given

the apparent lack of political support within and

across some countries, and the limited policy tools

available. Across many countries, prices of shares andother risk assets have declined sharply since early

Graph 1.2

l l l l l l l l l l l l l l0

25

50

75

100

0

25

50

75

100

Banks Share Prices

1 January 2008 = 100

* Diversified financials** MSCI financials indexSource: Bloomberg

US*

Index Index

UK

Australia

Euro areaAsia**

(excluding Japan)

Japan

M 2008J S D 2009 2010 2011

Canada

M J S D M J S D M J S

August. Bank and insurer share prices have been

particularly affected, falling by more than 15 per cent

in most countries, to be around their lowest levels

since early 2009 (Graph 1.2). Credit markets have


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also tightened globally, although conditions are still

generally better than they were during the height of

the crisis in 200809.

This current episode of risk aversion and volatility

follows a number of periods of heightened market

turbulence over the past couple of years. These

periodic events indicate that financial market

participants remain sensitive to bad news following

the experience of 200809. While the latest bout of

market uncertainty is not on the scale of 200809,

it is unclear at this stage whether it will be another

temporary episode or whether it is foreshadowing a

more serious market dislocation.

Compared to the pre-crisis period, the large banks

in the major advanced economies are better placed

to withstand a period of renewed market stress. In

particular, they have significantly strengthened their

capital positions over the past few years and there

is now less uncertainty about banks exposures than

there was during the crisis. Funding structures have

also generally been improved, although some banks

are still relatively reliant on short-term wholesale

funding and are therefore susceptible to marketstrains. Most large banks have continued to post

solid profits over recent periods. Even so, a further

escalation in sovereign strains within Europe could

adversely affect some large banks by increasing their

funding costs and causing asset write-downs. Many

of these banks are also vulnerable to a slowing in the

pace of economic recovery because they stil l have an

elevated level of non-performing loans, particularly

property-related loans, and property markets are still

weak in many advanced economies.

Banking systems in emerging Asia remain in much

better shape than those in the major advanced

economies. The profitability of large banks in the

Asian region has been strong recently, supported

by robust growth in deposits and lending. These

banks are relatively well placed to cope with the

current market strains: they are largely focused on

strongly growing domestic markets and have little

direct exposure to euro area sovereigns and banks.However, asset prices and credit have been growing

strongly in a few Asian countries, so any unwinding

in asset markets there could expose credit quality

problems.

Global reinsurers and general insurers have been

dealing with a number of large catastrophe events

in 2011. While these firms have experienced

significantly lower profits as a result, they have

maintained high capital buffers.

Sovereign Debt Concerns

Market concerns about the sustainability of some

countries sovereign debt positions in Europe

intensified over the past six months. Portugal came

under significant funding pressure during March

and April, forcing it to request international financial

assistance from the European Union (EU) and

International Monetary Fund (IMF). A rescue package

was announced in early May, making Portugal the

third euro area country to receive a bailout after

Greece and Ireland in 2010.

Greece also came under renewed market pressure

during the past six months because of difficulties

in meeting the terms of its 2010 bailout package.

Concerns that it would be unable to re-enter debtmarkets in 2012 as previously assumed raised the

prospect of a further funding shortfall. Protracted

negotiations over another assistance package and

demands for private-sector burden-sharing caused

significant uncertainty in markets around the middle

of the year. A second EU/IMF rescue package for

Greece was eventually announced in July. It aims

to improve Greeces long-term debt position by

extending the maturities and reducing the interest

rates on its new EU loans (these more generous loan

terms will also be applied to Ireland and Portugal),

and by providing funding to buy back debt from

private investors. The revised program also envisages

that part of the funding shortfall will be met from

private investors rolling over debt and exchanging

existing bonds for new bonds with longer maturities,

with these measures expected to result in private

investor losses on Greek sovereign debt of about

20per cent on average. In addition, Greece agreedto implement tougher fiscal tightening measures

and sell some state assets. Even with these measures,


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the IMF is forecasting Greeces public debt-to-GDP

ratio to continue to rise sharply in 2012 due to

further fiscal deficits and weak economic conditions

(Graph 1.3).

While the second assistance package for Greece is

yet to be fully approved, deteriorating economic

conditions mean the country has been struggling

to meet the terms of its original bailout package.

This has contributed to uncertainty about whether

further tranches of financial assistance under the

first package will be provided by the EU and IMF,

which has been weighing on market sentiment in

recent weeks. Associated with this, there has been

increasing market speculation that Greece maydefault, and spreads on Greek government debt

have risen sharply as a result (Graph 1.4). By contrast,

market sentiment towards Ireland has improved over

recent months, with 10-year Irish government bond

yields declining by about 5 percentage points

since mid July. Underlying this, market participants

seem increasingly confident that Ireland will meet

the fiscal and banking reform targets set out in its

international assistance package.

More generally, to help support financial stability

in the region, EU authorities have in recent months

announced plans to expand the role of the

European Financial Stability Facility (EFSF), and its

replacement from mid 2013, the European Stability

Mechanism (ESM), including by allowing them to

purchase sovereign debt on secondary markets

and finance bank recapitalisations. The effective

lending capacity of the EFSF was also increased to

440 billion (about 50 billion is already allocated), or500 billion in the case of the ESM. However, some

market commentators continue to doubt whether

these facilities would be sufficient to resolve funding

difficulties for some large euro area sovereigns with

high debt if they were to get into trouble. Indeed,

concerns about sovereign debt sustainability in Italy

and Spain escalated in July. Government bond yields

in these countries rose briefly to their highest levels

since at least the introduction of the euro in 1999.

S&P downgraded Italys credit rating from A+ to A

Graph 1.3

0

50

100

150

200

250

Per cent of GDP

General Government Gross Debt*

%

2016

Japan

* Dotted lines represent IMF forecastsSource: IMF

0

50

100

150

200

250

201120062016201120062001

Belgium

France

Greece

Italy US

Germany

UKIreland

Spain

Portugal

%

Australia

Graph 1.4

Spainl l l0

500

European Government Bond Spreads

Bps

Greece

Source: Bloomberg

Ireland

Portugal

Italy

To 10-year German Bunds

Bps

2009

France

l l l 0

500

1 000

1 500

1 000

1 500

20112009 2011

Belgium

2 0002 000

(with a negative outlook) in mid September, in part

due to weaker economic growth prospects.

With the changes to the EFSF yet to be approved

by national parliaments, the European Central Bank

(ECB) resumed purchases of euro area government

debt in secondary markets in August under its

Securities Markets Program. Around 150 billion

of sovereign debt has been purchased since the

inception of this program, with recent purchases of

about 80 billion believed to comprise mostly Italian

and Spanish sovereign bonds. The yields on these

countries long-term bonds initially fell noticeably,but have subsequently risen again in association with


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fears over softening regional economic conditions

and delays in the establishment of the second Greek

rescue package.

Although not as pressing as the situation in the

euro area, there have also been concerns about

government debt sustainability in the United States

and Japan. Government debt-to-GDP ratios are high

in both of these countries, especially so in the case of

Japan, and are projected by the IMF to continue to

rise over the next four years at least (Graph 1.3). S&P

downgraded the US credit rating from AAA to AA+

(with a negative outlook) in August based on its view

that the US political system may be unable to reach

agreement on the fiscal consolidation measuresrequired to restore the United States to a sustainable

fiscal path. S&P subsequently downgraded the

credit ratings of a number of US agencies, banks and

clearinghouses whose status is dependent on that

of the sovereign. This contributed to the increased

market turbulence in August. Japans sovereign credit

rating was also downgraded in August; Moodys

reduced the rating one notch to the equivalent of

AA-, bringing it into line with S&Ps rating, which had

been downgraded earlier in the year. Despite rating

changes, long-term government bond yields in the

United States and Japan have fallen since the start of

August as risk aversion has grown.

The severe market reactions to the deteriorating

sovereign debt positions have left governments

with a difficult balancing act: credible fiscal

consolidation plans are required to allay concerns

about debt sustainability, yet tightening budget

positions too much and too early may undermineeconomic recovery and thus fiscal positions. A

further complication is that there is less scope

for monetary policy in the affected countries

to counterbalance any fiscal consolidation. The

governments of a number of European countries

have recently introduced some further short- and

medium-term fiscal consolidation measures, but

market participants are pressuring some of them to

strengthen these plans.

The Impact of Sovereign CreditRisk on Bank Funding

An increase in sovereign credit risk can adversely

affect banks balance sheets and funding in severalways. It can induce losses on banks direct holdings of

government debt; reduce the value of the collateral

banks use to raise funding; and reduce the funding

benefit banks receive from implicit and explicit

government support.1 Accordingly, sovereign credit

rating downgrades often lead to downgrades

of those countries domestic banks. Moreover,

sovereign risk in one country can spill over to banks

in other countries through a number of channels,

including through banks holdings of foreign

sovereign debt, cross-border exposures to other

banks and claims on non-financial entities in affected

foreign countries. These kinds of inter-linkages have

been particularly important within the euro area in

recent months.

Concerns about sovereign risk in Greece, Ireland and

Portugal have been contributing to difficult funding

conditions for banks in these countries for some

time, compounding the problems they were alreadyfacing from weak domestic economic conditions

and property prices. As these countries sovereign

credit ratings have been progressively downgraded,

many of their banks have also had their ratings

downgraded (generally to below investment grade).

Funding spreads for these banks have widened

sharply, making it difficult for them to raise wholesale

debt, and forcing them to rely more on central bank

funding or other forms of official support. As at end

July, central bank lending was equivalent to about

20 to 25 per cent of Greek and Irish banks assets and

around 8 per cent of Portuguese banks assets.

Despite stronger competition for deposits, banks

in some of these countries have also experienced

substantial deposit outflows. Greek banks domestic

private sector deposits have declined by about

one-fifth since the end of 2009, with reports that

1 Committee on the Global Financial System (2011), The Impact of

Sovereign Credit Risk on Bank Funding Conditions, CGFS Papers,

No 43, July.


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depositors have been shifting money to other

countries on concerns about possible devaluation

in the event that Greece abandons the euro

(Graph 1.5). Irish banks have also experienced

significant deposit outflows, especially of non-

residents deposits, which have declined by more

than 25 per cent since mid 2010, compared with

a 7 per cent fall in residents deposits. By contrast,

deposits in Portuguese and Spanish banks have

generally held up over the past year.

Italian banks, which have significant exposures

to the Italian sovereign, have also come under

greater funding pressure in recent months as

sovereign debt concerns have spread to Italy.

Their borrowing from the ECB has increased

substantially since June, from 40 billion to85 billion, equivalent to about 2 per cent of their

assets. Spanish banks have also increased their

borrowing from the ECB over the past couple

of months. Compared with Greece, Ireland and

Portugal, increases in sovereign risk in Italy and

Spain have the potential for much larger regional

repercussions given the greater amount of their

debt on issue and its wider distribution within

the euro area. Excluding domestic banks, net

Graph 1.5

-24

-16

-8

0

8

-24

-16

-8

0

8

Banks Domestic Private Sector Deposits*Cumulative percentage change from end December 2009

* Excludes repurchase agreements** Includes deposits at non-bank financial institutions, and for the euro area,

non-central government depositsSources: ECB; central banks

Greece

Euro area**

Spain**

Portugal**

%

Ireland includingnon-residents

D M J S D M

2010 2011

J

%

2009

Ireland

Graph 1.6

EU Banks Sovereign Exposures*Per cent of aggregate core Tier 1 capital, as at end December 2010

Spain

Slovenia

Slovakia

Portugal

Netherlands

Malta

Luxembourg

Italy

Ireland

Greece

Germany

France

Finland

Estonia

Cyprus

Belgium

Austria

0 10 20 30 40 %

nDomesticnForeign - euro arean Foreign - other EU

* Exposures to euro area sovereigns only; direct exposures net ofcash short positions for banks participating in the EU stress test,which represent about 65 per cent of EU banking system assets

Source: EBA

Euro

area

so

vereigns

Bank domicile:

exposures of European banks to Italian sovereign

debt are equivalent to around 13 per cent of these

banks aggregate core Tier 1 capital, compared with

4 per cent for Spanish sovereign debt, and 6 per

cent for Greek, Irish and Portuguese sovereign debt

combined (Graph 1.6).

As sovereign risk has spread to a broader range

of countries, investors have become increasingly

concerned about the exposures of some of the

larger European banking systems to banks and

sovereigns of the affected countries (Table 1.1).

Many large European banks are also exposed

through their direct lending to households and

businesses in these countries, the performanceof which would be expected to deteriorate if

sovereign or banking strains exacerbated the

weakness in local economic conditions. Reflecting

these significant cross-border exposures, CDS premia

for banks in France and Germany have recently

widened and their share prices have fallen sharply

(Graph 1.7). Moodys downgraded the credit rating

of a large French bank in mid September because of

its significant exposure to Greece.


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Graph 1.7

l l l l l l l l l l l l l l0

25

50

75

100

0

25

50

75

100

Euro Area Banks Share Prices1 January 2008 = 100

Greece

Germany

Spain

Portugal

Index Index

M

2008

Ireland

J S D M J S D M J S D M

2009 2010 2011

J S

Italy*

France

* MSCI diversified financialsSource: Bloomberg

Table 1.1: Foreign Bank Claims on Euro Area Countries(a)

Ultimate risk basis, as at 31 March 2011, per cent of lending countrys total bank assets (b)

Reporting banks

(by headquarter

location) Greece Ireland Italy Portugal Spain Subtotal

Total

euro area

Euro area banks 0.2 0.5 1.6 0.4 1.1 3.9 10.5

of which:

Belgian 0.1 1.7 1.6 0.2 1.4 5.1 12.9

Dutch 0.2 0.6 1.5 0.2 2.4 4.9 18.2

French 0.5 0.3 3.8 0.3 1.3 6.2 13.2

German 0.2 1.0 1.5 0.3 1.6 4.6 10.9

Italian 0.1 0.3 0.1 0.6 1.0 10.6

Portuguese 1.3 0.7 0.4 3.5 5.9 9.5

Spanish 0.0 0.2 0.7 1.8 2.8 5.4

Swiss banks 0.1 0.5 0.7 0.1 0.8 2.2 12.6

UK banks 0.1 1.2 0.6 0.2 0.9 3.1 9.3

US banks 0.1 0.3 0.3 0.0 0.3 1.0 5.1

Japanese banks 0.0 0.2 0.4 0.0 0.2 0.9 4.4

Australian banks 0.2 0.1 0.1 0.3 1.8

(a) Based on 24 countries reporting to the BIS(b) Monetary financial institutions assets used as a proxy for total bank assets for countries in the euro area and the United KingdomSources: BIS; RBA; Thomson Reuters; central banks

Concerns about banks exposures within the euro

area have contributed to a tightening of credit

markets in recent months, although conditions

remain better than in 200809. In money markets,

the spread between 3-month interbank lending

rates (Euribor) and expected overnight rates has

risen by more than 45 basis points since the start

of August, to the highest level since early 2009

(Graph 1.8). US dollar funding pressures have also

emerged as access to US commercial paper and

deposit markets have been curtailed. US money

market funds, which are significant providers of

short-term US dollar funding to European banks,

have experienced sizeable investor outflows

in recent months. While these money market

funds had already all but stopped their lendingto banks in Greece, Ireland, Italy, Portugal and

Spain, they have recently also been reducing

and shortening their exposures to banks in other

euro area countries. In response, the ECB and four

other major central banks recently announced

co-ordinated 3-month US dollar liquidity operations

on specific dates later this year. These operations

are in addition to the seven-day US dollar liquidity

facilities already offered by the ECB and the Bank

of England.


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Graph 1.8

l l l l0

50

100

150

200

0

50

100

150

200

3-month Euribor SpreadTo overnight indexed swaps

Source: Bloomberg

Bps Bps

2007 2008 2009 2010 2011

Graph 1.9

l l l l l0

500

Banks Bond SpreadsTo equivalent maturity government bonds

Source: Bloomberg

Bps

2007 2009

AAA

2011

BpsUS

l l l l l 0

500

Euro area

2009 20112007

BBB

1 000

1 500

2 500

2 000

1 000

1 500

2 500

2 000Coveredbonds

3 000 3 000

Graph 1.10

0

75

150

0

75

150

20

40

20

40

Euro Area Banks Bond Issuance*

* September 2011 is quarter-to-dateSources: Dealogic; RBA

Belgium, Italy and Spain

nCovered bonds nGovernment-guaranteed nUnguaranteed

50

100

50

100

Other euro area

Greece, Ireland and Portugal

201120092007 2008 2010

Spreads on longer-term bank debt in the euro area

have now increased to above the levels seen in mid

2010, although for higher-rated unsecured bonds

and covered bonds these increases are entirely due

to lower benchmark sovereign yields (Graph 1.9).

Consistent with this shift in credit market conditions,

bond issuance by euro area banks has slowed in

recent months (Graph 1.10). However, issuance

(other than by Greek, Irish and Portuguese banks) had

been strong earlier this year, suggesting that some

banks may not need to access term debt markets

in the near future. The larger European banks have

also bolstered their liquidity positions since the crisis.

Even so, many of them are still relatively reliant on

wholesale funding, including short-term US dollar

funding. There is a risk, therefore, that if the sovereign

debt problems in Europe were to deepen or become

more protracted, these larger European banks couldencounter more severe funding strains, which could

then propagate stresses more broadly in the global

financial system.

While heightened risk aversion associated with the

sovereign debt problems in Europe has resulted

in a sharp increase in global market volatility over

the past couple of months, bank funding markets

outside the euro area have so far been less affected.

Short-term interbank spreads have increased by

much less in the United States and United Kingdom

this year than in the euro area. Bank bond spreads

have widened across a number of markets, although

the increases for lower-rated issuers have been less

than in the euro area. Large banks in the United Statesand United Kingdom have significantly increased the

share of their funding from deposits over the past

few years, which should make them more resilient to

stresses in wholesale funding markets.

Bank Capital

Bank capital positions have been strengthened

substantially since the 2008 crisis, increasing the

resilience of the major banking systems, and in

principle helping them to cope with a renewed

period of market stress. Progress in improving bank


14/72


capital positions has tended to be slower in the euro

area than in other regions over the past few years,

although recently there has been a more concerted

effort to raise additional capital.

Bank supervisors in a number of the troubled euro

area countries have recently raised the minimum

core Tier 1 capital requirements for their banks, to

levels above the future Basel III requirements, and

with a shorter timetable for adherence (Table 1.2).

This has forced some banks in these countries to

raise capital, either privately or from the government,

including from funds set aside in international

financial assistance programs. The aim of these

measures is to shore up market confidence in bankssolvency given the weak domestic economies and

their sizeable exposures to domestic sovereign debt.

More generally, the recently completed EU-wide

bank stress test has provided some impetus for

improving bank capitalisation in the region. The

results of the stress test, published by the European

Banking Authority (EBA) in July, included detailed

information on the capital positions of 90 EU banks

(representing about 65 per cent of EU banking

system assets). Capital raisings and other measures

affecting bank capital positions (such as mandatory

restructuring plans) were required to be publicly

announced and committed to by end April if they

were to be included in capital for the purposes of

the test. In aggregate, participating banks undertook

50 billion in approved capital measures in the first

four months of 2011, adding 0.4 percentage points

to their aggregate end 2010 core Tier 1 capital ratio

of 8.9 per cent.

The EU stress test found that the majority of

participating banks maintained reasonable capital

buffers under a two-year stress scenario for the

macroeconomy and financial markets. Eight

relatively small banks failed to meet the benchmark

5 per cent core Tier 1 capital ratio under the stress

scenario (see Box A: European Bank Stress Tests).

Nearly all of these banks were from countries where

bank supervisors have already raised the minimum

core Tier 1 capital requirement.

Detailed information on participating banks

sovereign and other exposures to individual EU

countries were disclosed in conjunction with the

EU stress test results. This enhanced transparency

should mean there is less uncertainty about EU

banks problem exposures than there was during the

2008 crisis, along with the fact that these exposures

are less complex than the structured securities

that triggered the crisis. While this transparency

should help limit any contagion effects, market

participants seem increasingly concerned about

the creditworthiness of some EU banks exposures

to euro area countries where the economic outlook

has deteriorated noticeably since the EU stress test

was conducted. This, in turn, has raised questions

Table 1.2: Core Tier 1 Capital Ratios for Banks in Selected Euro Area Countries

Minimum requirement Supervisory deadline

Per cent of risk-weighted assets

Cyprus 8 July 2011

Greece 10 January 2012

Ireland 10 March 2011

Portugal 9 and 10 End 2011 and end 2012

Spain 8 or 10(a) September 2011

Memo items:

Basel III common equity Tier 1 3 and 4 January 2013 and 2015

Basel III common equity Tier 1

plus conservation buffer7 January 2019

(a) Minimum requirement is 10 per cent for those banks which are not listed or are more reliant on wholesale fundingSources: BCBS; national authorities


15/72


Graph 1.11

0

4

8

12

0

4

8

12

Large Banks Tier 1 Capital*

US

% %

Euro area Japan Canada

Per cent of risk-weighted assets

* Tier 1 capital ratios across banking systems are subject to definitionaldifferences; includes the weighted average of: 19 large US banks, 52 largeinstitutions from across the euro area, the five largest UK banks, the threelargest Japanese banks and the six largest Canadian banks

** End June for US, euro area, UK and Japan; end July for CanadaSources: Bloomberg; CEBS; EBA; FDIC; RBA; banks annual and interim reports

UK

n Mid 2011**n2010n2007 n 2008 n 2009

about the adequacy of these banks capital and

funding positions.

Outside the euro area, bank capital positions have

been strengthened further in most other major

banking systems during the past year. Recent

increases in Tier 1 capital ratios for banks in the

United States, United Kingdom, Japan and Canada

have generally been smaller than in the euro area,

but this mainly reflects that these banks bolstered

their capital positions to higher levels in 2009 and

2010 (Graph 1.11). Unlike in the euro area, most

of these banks have recently been accumulating

capital largely through retaining earnings rather

than raising new equity. Internal capital generationfor the large US and UK banks has been aided by

dividend payout ratios that are still below pre-crisis

levels. Capital ratios have also been supported by

slow growth in risk-weighted assets, in line with

subdued credit growth.

Bank Profitability

The large banks in the major advanced countries

generally continued to report profits in the first half

of 2011, although results were quite mixed across

institutions, and overall profit levels and returnson equity remained subdued compared to the

pre-crisis period (Graph 1.12). Whereas declining

0

15

0

15

%

* Return on equity of the six largest US banks, 10 largest listed Europeanbanks (including Switzerland), five largest UK banks, four largest Japanesebanks and six largest Canadian banks; 2011 profit is annualised and totalequity is assumed constant from last reporting date

** 200107 results are to fiscal year ended 31 MarchSources: Bloomberg; RBA; banks annual and interim reports

-40

-20

0

-40

-20

0

%

After tax and minority interests

Large Banks Return on Equity*

US

Europe

UK

Japan**

Canada

201120092007200520032001

% %

loan-loss provisions had supported banks profit

growth in 2010, provisions have fallen more

modestly or been stable in recent periods. Trading

income has tended to be volatile, reflecting shifts

in market conditions, but was generally weaker for

most large banks in the first half of 2011 than a year

earlier. With net interest margins broadly steady,

weak credit growth across the major banking

systems has meant that growth in net interest

income remains subdued.

Ongoing weak credit growth has been associated

with continued weakness in property markets

and hesitant economic growth in the major

economies. The level of household credit (which

mainly comprises housing credit) is still falling

in the United States, and while household credit

growth has recovered over the past year or so in

the euro area, recent outcomes have been softer

(Graph 1.13). Business credit has been even weaker

and is still falling in the United Kingdom and the

United States, although the rate of contraction is

less than in 2009 and early 2010. Loan officer surveys

generally indicate that demand for credit remains

subdued. This is particularly the case for households,

consistent with weak housing market conditions,high debt burdens and high unemployment.

Graph 1.12


16/72


Graph 1.13

-20

-10

0

10

20

Credit GrowthSix-month-ended annualised, seasonally adjusted

Euro area*

%

UK

% Business

US

2011

* Euro area data not adjusted for securitisations prior to 2009Sources: Bank of England; ECB; RBA; Thomson Reuters

Household

20072003-20

-10

0

10

20

201120072003

Aggregate profits of the six largest banking groups

in the United States (representing around one-

half of US banking system assets) were held down

in the first half of 2011 by a large second-quarter

loss at Bank of America. Bank of Americas loss was

mainly due to expenses related to buybacks of

poorly underwritten mortgages and related legal

costs. Profits of the remaining five large US banks

were around 8 per cent higher than the year before,

supported by further modest declines in loan-

loss provisions. Some US banks are still facing the

prospect of further large expenses related to the

resolution of previous poor mortgage practices.

Across all US Federal Deposit Insurance Corporation

(FDIC) insured institutions, profits in the first half

of 2011 were much higher than a year earlier, with

results for smaller institutions improving noticeably.

In Europe, aggregate profits of the 10 largest banking

groups (including two Swiss banks) were around

7 per cent lower over the year to the first half of 2011,

in part reflecting difficult trading conditions for some

banks related to the sovereign debt problems in

Europe. Some large euro area and UK banks have also

had to set aside significant provisions for expected

losses on Greek sovereign debt held in their banking

books. More recently, the Swiss bank UBS revealed

estimated losses of around US$2.3 billion incurredfollowing unauthorised trading; these losses will

affect its profits for the second half of 2011. Profits

of the large UK banks were mixed in the first half of

2011: those with significant exposures to emerging

markets recorded growth in profits, while others

continued to record losses, mainly due to substantial

compensation payments to customers who were

previously mis-sold loan payment protection

insurance. For the large Japanese banks, profits in the

first half of 2011 were about 4 per cent lower than

a year earlier, although they were little affected by

the earthquake and tsunami in March. The largest

Canadian banks generally continued to post solid

results in the latest half year, although one bank

recorded a large fall in profits due to a loss on the

sale of its US banking business.

The difficult macro-financial environment in the

major economies continues to cloud the outlook

for bank profitability. In the near term, the renewed

market turmoil may result in some losses in banks

trading books and may adversely affect their

investment banking revenues. Profits would be more

severely affected if the sovereign debt problems in

Europe were to escalate further, resulting in higher

funding costs and more asset write-downs. Investors

appear to be pessimistic about banks future

profitability, with the market valuation of many large

banks in the euro area, the United Kingdom and

the United States falling below the book valuation

reported in their financial statements (Graph 1.14).

Graph 1.14

0

1

2

3

0

1

2

3

Banks Price-to-book-value Ratios*

2011

Australia

* Monthly; September 2011 observation is latest available** Diversified financialsSource: Bloomberg

Ratio

200920072005

US**

UK

Canada

Euro area

Ratio


17/72


Property-related exposures remain another key

vulnerability for banks in the major advanced

countries. In the United States, non-performing loan

ratios for both commercial and residential property

remain around their historical highs, despite small

declines since early 2010 (Graph 1.15). Troubled

property exposures, particularly commercial real

estate loans, continue to contribute to failures

among smaller banks in the United States. Over the

year to date, there have been 71 failures of FDIC-

insured institutions in the United States; although

this number represents only about 1 per cent of

all US FDIC-insured institutions, more than 10 per

cent of institutions are still considered vulnerable

by the FDIC, a slightly larger proportion than

the 1990 peak. In Europe, non-performing loans

have continued to increase for many banks that

have significant exposures to depressed property

development markets. The available nationwide

data indicate that bank non-performing loan ratios

have increased further in Ireland and Spain over the

past year.

Improved performance of these exposures would

require a durable recovery in economic and property

market conditions. Many commercial and residential

property exposures are likely to be in negative equity,

as property prices remain well below their peaks

in most countries (Graph 1.16). Commercial and

residential property prices continued to fall in the

United States over the past year, as well as in a

number of European countries, including Ireland

and Spain two countries that have experienced

particularly large booms and busts in propertydevelopment. Authorities in some jurisdictions have

been concerned about forbearance of property (and

other) loans by banks, such as by extending loan

maturities or converting loans to interest-only terms.

These actions help borrowers cope with temporary

periods of financial distress and avoid the need for

banks to sell assets into already depressed markets.

However, they could leave banks under-provisioned

if economic and financial conditions turn out weaker

than expected. The slowing in economic activity in

some of these countries since mid year suggests an

increasing likelihood that this risk will be realised.

Over the longer term, it is likely that banks and the

investor community will need to lower their return

expectations. Many banks need to continue to

increase their common equity positions to meet

the Basel III requirements, and in some cases, the

extra capital buffers that the Financial Stability Board

and Basel Committee on Banking Supervision have

proposed to apply to global systemically important

banks (see the Developments in the Financial

Graph 1.15

0

2

4

6

8

US Non-performing Loans*Per cent of loans

2011

% %

20041997

Commercialreal estate**

0

2

4

6

8

Total By loan type

Commercial

Consumer

201120041997

Residentialreal estate

1990

* FDIC-insured institutions** Includes construction and development loans

Source: FDIC

Graph 1.16

l l l l l l l l 50

100

150

200

Property Price Indicators

2011

UK

l l l l l l l l50

100

150

200

Index

Sources: Bloomberg; Jones Lang LaSalle; Property Council of Australia;RBA; RP Data-Rismark; Thomson Reuters

Commercial real estate Residential real estate

200720112007

US

31 December 2002 = 100

Index

2003

Ireland

SpainFrance

Australia


18/72


System Architecture chapter). While this should

make them more resilient, it means their returns

over the medium term are likely to be lower than

before the crisis. Capital positions will need to be

built up partly via banks preserving a higher share

of internally generated revenue than in the pre-crisis

period for example, by lowering dividend payout

ratios or reducing the share of revenue paid to

employees. But the task of revenue generation will

also be challenged by a regulatory and supervisory

framework that will, appropriately, limit bank risk-

taking compared to the recent past. Although

some large banks have lowered their target returns

below the rates seen in the few years before the

crisis, in many cases these targets remain high when

compared with returns achieved over a longer

period. If banks and their investors continue to

target unrealistic returns, then they may take on risks

that could ultimately sow the seeds for future

financial distress.

Banking Systems in Emerging Asia

Banking systems in the emerging Asian region

remain in much better shape than many of those

in the major advanced economies. While Asian

banks were not completely immune from the global

financial and economic strains during the crisis,

their focus on strongly growing domestic banking

markets and their relatively low reliance on offshore

wholesale funding sources partly insulated them.

They largely avoided building up portfolios of the

types of structured securities that banks in the North

Atlantic region have had to write down. As such,with a few exceptions, banks in the Asian region did

not require public sector capital support. Given their

domestic focus, Asian banks are well placed to cope

with the current market stresses stemming from the

sovereign debt problems in Europe, because they

have little direct exposures to euro area sovereigns

or banks. However, spillovers to Asian economies

and their banking systems may occur if some large

European banks are forced to reduce their exposures

in Asia.

The profitability of the large Asian banks has

generally remained strong in 2010 and early 2011,

with after-tax returns on equity ranging from about

10 to 25 per cent, around the rates seen in the years

leading up to the financial crisis. This compares

with lower post-crisis average returns of around

5 to 10 per cent for large banks in the United States,

United Kingdom, and the euro area. Asian banks

profitability has been supported by robust growth

in deposits and lending amid strong economic

conditions and high domestic saving rates.

Real interest rates in some fast-growing Asian

economies have remained low or negative for some

time, despite gradual policy tightening. Credit hastherefore expanded at a strong pace over recent

years, contributing to significant rises in asset prices

in a few countries. Residential property prices in

Hong Kong, Taiwan, Singapore and some large cities

in China have increased considerably (Graph 1.17). If

property prices were to unwind, credit quality could

decline. Banks exposures to property development

companies would be most problematic in such a

scenario: lending standards for residential mortgages

tend to be relatively conservative and have been

tightened by supervisors in some countries in recent

years. Regulatory impositions for mortgages have

Graph 1.17

0

50

100

150

200

Asset Prices and Credit

2003

China

2011199520111995

Hong KongSAR

Singapore

Index %

2003* Adjusted for inflation; for China, data are an average of new and existing

residential property prices

Residential property prices*June 2005 = 100

Credit-to-GDP

40

70

100

130

160

Taiwan

Sources: CEIC; Central Bank of Taiwan; Hong Kong Monetary Authority;Monetary Authority of Singapore; RBA


19/72


included increases in minimum down-payment

requirements, and introducing or increasing taxes

on certain property sales.

The Chinese authorities, in particular, have sought

to tighten credit conditions over the past year or

so. They have raised banks required reserves and

imposed strict controls over lending, including

restrictions on lending for mortgages and to local

government entities. It is thought that some of the

lending to local governments over recent years was

directed to projects that are not commercially viable,

which raises asset quality concerns. According to

recent estimates by the Chinese national auditors,

bank loans to local governments as at the end of2010 were equivalent to around 20per cent of GDP,or 10 per cent of banking system assets. Despite

these policy actions, however, various forms of off-

balance sheet lending (such as bank-accepted bills)

have continued to grow strongly. Including off-

balance sheet credit, the overall credit-to-GDP ratio

in China had increased to about 130 per cent by mid

2011 a high ratio relative to countries at the same

per capita income level.

At this stage, Chinese banks loan portfolios have not

deteriorated: the non-performing loan ratio for all

commercial banks fell over 2010, to 1.1 per cent, its

lowest level since at least prior to the Asian financial

crisis in the late 1990s (Graph 1.18). More recent data

indicate that the non-performing loan ratios of the

five largest banks (which represent around one-half

of Chinese banking sector assets) declined further

over the first half of 2011. The Chinese supervisory

authority has required banks to increase theirprovisions and capital buffers over recent years,

measures which should help banks deal with any

future increase in problem loans. Chinese banks

aggregate core Tier 1 capital ratio was 10 per cent

at end 2010 a higher ratio than in many advanced

economy banking systems, but low relative to other

Asian banking systems that are also experiencing

strong credit growth.

Graph 1.18

0

100

200

0

3

6

5

10

10

20

Chinese Banks Financial Position*

* Commercial banks only; excludes policy banks and credit co-operatives

Source: CBRC

Return on equity Capital adequacy ratio

Non-performing loans Provisions

%

2010200820102008

Per cent of non-performingPer cent of total loans

%

%

%

Core

assets

After-tax

Recent Catastrophe Lossesof Insurers

The global insurance industry has been challenged

by a spate of natural disasters in 2011. Insured

losses from catastrophes in the first half of 2011 are

estimated to be around US$70 billion, more than

double that in the first half of 2010 and around

five times higher than the six-monthly average ofthe previous decade (Graph 1.19). The high losses

are largely due to the earthquake and tsunami in

Japan: insured losses from this event are estimated

to be around US$30 billion, which would make it the

costliest natural disaster for insurers after Hurricane

Katrina in the United States in 2005. Insured losses

from the February Christchurch earthquake, and the

floods and Cyclone Yasi in Queensland, are estimated

to be around US$10 billion and US$3 billion,

respectively.

Claims from the recent natural disasters have

adversely affected the profitability of large global

reinsurers, which reported a small aggregate net loss

in the first half of 2011, equivalent to an annualised

after-tax return on equity of about per cent

(see Box B: The Global Reinsurance Industry). These

reinsurers were able to easily absorb these small losses

and maintain high capital buffers. The largest global

general insurers AIG, Allianz and Zurich Financial


20/72


Services also reported elevated catastrophe losses

in the first half of 2011, though they all remained

profitable because of favourable results for their

non-catastrophe insurance operations. A couple of

the large European insurers and reinsurers have also

recorded sizeable impairments on their exposures to

Greek debt in the most recent period.

Globally, share prices of insurance and reinsurance

firms have fallen more sharply than the broader

market since the start of August (Graph 1.20). This

likely reflects their sizeable sovereign exposures

and, more generally, market concerns about the

adverse impact of renewed debt and equity market

volatility on insurers investment portfolios, ratherthan their insurance operations. If this volatility were

to continue, investment losses could reduce insurers

profits. An additional risk to their future profits

would emerge if the current US hurricane season

were particularly severe, as this would generate

further significant catastrophe losses and may place

pressure on some insurers capital reserves. Insured

losses from Hurricane Irene in the United States in

late August are not expected to be as high as those

from major catastrophe events earlier in 2011, with

initial estimates around US$27 billion.

Graph 1.19

0

25

50

75

100

0

25

50

75

100

June 2011 prices

Global Catastrophe Insurance Claims*

US$b

2011

* Data for 2011 are for the June 2011 half yearSources: RBA; Swiss Re

20041997199019831976

US$b

Graph 1.20

l l l l l l l l l l l l l l 0

25

50

75

100

0

25

50

75

100

Insurers Share Prices

* Market-capitalisation-weighted index of seven large reinsurersSources: Bloomberg; RBA

US insurers

1 January 2008 = 100

Index Index

Reinsurers*

European insurers

M

2008

J S D

2009 2010 2011

M J S D M J S D M J S


21/72

Financial Stability Review | S e p t e m b e r 2 0 1 1 19

Stress tests are a common risk management tool

used by financial institutions. Prudential supervisors

also use stress tests to assess vulnerabilities facing

individual financial institutions and financial systems

as a whole. These tests typically involve specifying a

scenario in which economic and financial variables

shift adversely, and then estimating the impact on

financial institutions asset portfolios and capital,

as well as other key metrics. The results allow

supervisors to identify potential weaknesses and

risks in financial institutions, which can then prompt

corrective actions.1 The global financial crisis has

significantly increased the focus on stress testing

given the strained conditions in many advanced

country banking systems.

Like most prudential supervisory activity, the results

of stress tests for individual financial institutions areusually kept confidential. This allows supervisors to

probe vulnerabilities among financial institutions

using more severe scenarios without creating

unnecessary public concern about unlikely events.

Since the beginning of the financial crisis, however,

supervisors in some jurisdictions have chosen

to publish the results for individual institutions

from industry-wide stress tests for example, US

supervisors released stress test results for 19 large

US banking groups in May 2009. Publication has

been aimed at reducing uncertainty about the

soundness of individual banks, and thus improving

market confidence in the broader banking system.

It can also be designed to provide authorities with

the legitimacy to address weak institutions. In these

cases, the stressed or adverse scenario is generally

1 A discussion of the different types of stress testing used by

financial institutions and supervisors can be found in APRA

(2010), Stress-testing for authorised deposit-taking institutions,APRA Insight, Issue 2, pp 212.

Box A

European Bank Stress Tests

constructed to be less unlikely than in unpublished

tests, and the baseline scenario often already

involves some degree of stress.

The large banks in the European Union (EU) were

subjected to a stress test in 2010, and again earlier

this year, and the individual results of both were

published. The 2010 stress test was co-ordinated bythe Committee of European Banking Supervisors

(CEBS), an advisory body comprising representatives

from the various national supervisory agencies. The

publication of the results from this stress test in

July 2010 initially helped to calm market sentiment

about the health of European banking systems and

their resilience to sovereign debt problems, which

had intensified earlier that year. But a few aspects

of the methodology for the 2010 stress test were

criticised by some commentators. First, a sovereigndefault was not incorporated in the scenario

despite growing market concerns at the time about

sovereign debt sustainability for a few euro area

countries. While sovereign debt exposures in the

participating banks trading books were required

to be marked down, the much larger sovereign

exposures in their banking books were not stressed.

Second, the capital benchmark chosen a 6 per

cent Tier 1 capital ratio was inconsistently defined

by national supervisors and deemed too easy to

pass. Indeed, two Irish banks that met the capital

benchmark under the adverse scenario were later

found to require significant additional capital, the

majority of which has since been provided by the

Irish Government.

To alleviate continuing market concerns about

the health of European banking systems, a second

EU-wide bank stress test was conducted earlier this

year by the European Banking Authority (EBA), the


22/72

ReseRve Bank of austRalia20

successor to the CEBS. The 2011 stress test was applied

to 91 institutions, representing about 65 per cent of EU

banking sector assets and a minimum of 50 per cent ofbank assets in each of the 21 participating countries.2

The Spanish central bank, which is also the bank

supervisor, took the approach of requiring almost all of

its domestic banks to participate in the test.

The stress test required banks to estimate their credit

impairments, trading losses and capital position,

under both a baseline and an adverse scenario for

2011 and 2012. A number of aspects of this stress test

were toughened compared with the previous test.

The adverse economic scenarios were more

severe relative to the baseline scenarios and

more differentiated across countries. For

example, annual EU GDP growth under the

adverse scenario was 4 percentage points below

the baseline in the 2011 test, compared with

3 percentage points below for the 2010 test.

Banks were this time required to provision

for losses on their banking book sovereign

exposures based on assumed credit rating

downgrades for sovereigns rated below AAA as

at 1 June 2011 (two notches for sovereigns rated

AA to A- and four notches for sovereigns rated

BBB+ or below). Sovereign exposures were also

assumed to have a 40 per cent loss given default.

A funding cost shock was introduced. Banks

funding costs were increased in line with

assumed sovereign spreads (to the German

sovereign). It was assumed that at least one-half

of the increase in funding costs could not be

recovered from customers and therefore flowed

directly through to profits and capital.

A 5 per cent core Tier 1 ratio was consistently

adopted as the capital benchmark. This is a stricter

definition of capital than the 2010 Tier 1 definition

because it excludes capital with lower loss

absorbency, including most hybrid instruments.

2 Includes one bank from Norway, which is not part of the EU.

The stress test found that, under the adverse

scenario, the aggregate core Tier 1 capital ratio of

the participating banks would fall to 7.7 per centat the end of 2012, down from 8.9 per cent at

the end of 2010; it would reach 9.8 per cent under

the baseline scenario. Most banks were found to

exceed the capital benchmark under the adverse

scenario, although the results were quite dispersed

(Graph A1). Eight relatively small banks (five from

Spain, two from Greece and one from Austria)

failed to meet the benchmark 5 per cent core

Tier 1 capital ratio.3 The EBA recommended that

national supervisory authorities require these banks

to present plans for remedial actions within three

months and take action on these plans by end 2011.

The relevant national supervisory authorities stated

publicly at the time that these banks would have

passed the stress test if capital measures announced

or planned after the EBAs end-April deadline were

included and capital measures not recognised by the

EBA (such as general provisions) had been eligible.

A further 16 banks were estimated to have core Tier 1 capital ratios of between 5 and 6 per cent

under the adverse scenario. The EBA recommended

that supervisors request banks that had ratios above

but close to 5 per cent take steps to strengthen their

capital positions if they have sizeable exposures to

the sovereigns under most stress.

The decline in banks core Tier 1 capital ratios under

the adverse scenario largely reflected estimated

losses on their credit exposures. Credit impairments

reduced the aggregate core Tier 1 capital ratio of

the participating banks by 3.7 percentage points,

compared with a 0.5 percentage point reduction

from trading book losses and a 1.1 percentage

point decline due to higher risk-weighted assets.

These effects were partly offset by increases in

3 One German landesbank that would have also failed the

stress test pulled out of the test late in the process after deals

to convert local government silent participations a form of

hybrid capital into approved core capital were deemed

ineligible by the EBA. The results presented here therefore coveronly 90 banks.


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Financial Stability Review | S e p t e m b e r 2 0 1 1 21

banks underlying profits, which were estimated

to contribute about 3.7 percentage points to the

aggregate capital ratio under the adverse scenario.

Estimated credit impairments were particularly large

for some Irish and Greek banks, in part reflecting

tougher economic and property market assumptions

applied to these banks. Greek banks were also most

affected by impairments on sovereign debt given the

already low credit rating on Greek debt as at 1 June.

The participating banks starting capital ratios

were supported by recent capital raisings. In total,

50 billion in approved capital measures were

undertaken or confirmed in the first four months of

2011, adding 0.4 percentage points to the aggregate

core Tier 1 capital ratio. One-third of this capital was

from government sources. As at end April 2011,

38 participating banks had received public capital

support. Public capital accounted for an estimated

17 per cent of all participating banks aggregate core

Tier 1 capital, including capital measures that had

been confirmed but not yet implemented at this

time (Graph A2). Around three-quarters of this public

capital support was through ordinary shares and the

rest from other eligible instruments (for example,

preferred shares). The extent of government support

varied significantly across countries: there was no

support in a number of countries (such as France

and Sweden), while there was significant support in

others (such as Germany and the United Kingdom).

In Ireland, the large domestic banks are almostentirely owned by the Irish Government.

In conjunction with publishing the results of the

stress test, the EBA also disclosed detailed

information on participating banks sovereign

and other exposures to individual EU countries in

order to enhance market transparency. The data

on sovereign exposures were more extensive than

the previous year in that they were broken down

by maturity and included details on exposures

arising from derivative positions. Participating banks

As at 31 December 2012

* Including approved capital and restructuring measures taken orannounced and fully committed to by 30 April 2011

Source: EBA

23.5

20.4

Austria

-2.5 0.0 2.5 5.0 7.5 10.0 12.5

Luxembourg

Belgium

Cyprus

Denmark

Finland

France

Germany

Greece

Hungary

Ireland

Italy

Malta

Netherlands

Norway

Poland

Portugal

Slovenia

Spain

Sweden

UK

Weighted average

EBA benchmark

%

Banks Core Tier 1 Capital Ratio UnderAdverse Scenario*

Graph A1

Total

UK

Sweden

Spain

Slovenia

Portugal

Poland

NorwayNetherlands

Malta

Luxembourg

Italy

Ireland

Hungary

Greece

Germany

France

Finland

Denmark

Cyprus

Belgium

Austria

0 5 10 15

As at 30 April 2011

Components of BanksCore Tier 1 Capital Ratio*

%

nPrivate common equitynOrdinary government sharesnOther government support

* Including approved capital measures taken or announced and fullycommitted to by 30 April 2011

Source: EBA

Graph A2


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ReseRve Bank of austRalia22

together held about 1.8 trillion in EU government

debt at the end of 2010 (net of cash short positions),

equivalent to 16 per cent of their risk-weightedassets, and a little under one-fifth of total EU

general government debt outstanding (Table A1).

On average, exposures to home-country sovereign

Table A1: EU Banks Net Sovereign Debt Exposures(a) (b)

As at 31 December 2010, billion

Country of debt issuance

Memo

item:

Domestic

Greece

Portugal

and Ireland

Italy Spain Other EU(c) Total EU(c)

Sovereign debt held

by banks in:

Austria 0.6 1.2 0.2 43.3 45.3 13.9

Belgium 6.3 20.6 2.9 70.8 100.5 26.3

Cyprus 6.2 0.0 0.1 2.2 8.5 1.4

Denmark 0.5 0.4 0.1 13.6 14.7 5.7

Finland 0.0 0.0 0.9 1.0 0.4

France 15.0 41.1 9.3 199.2 264.5 102.5

Germany 12.0 32.9 17.1 363.8 425.8 305.5

Greece 48.4 0.1 3.6 52.1 48.4

Hungary 4.7 4.7 4.3

Ireland 10.4 0.8 0.3 5.3 17.0 10.2

Italy 1.9 159.0 3.0 38.4 202.2 159.0

Luxembourg 0.3 2.4 0.2 3.4 6.2 2.9

Malta 0.0 0.0 0.8 0.8 0.7

Netherlands 2.4 8.2 2.1 115.9 128.6 44.0

Norway 14.9 14.9 14.3

Poland 6.6 6.6 6.6

Portugal 20.9 1.0 0.3 1.9 24.0 18.9Slovenia 0.1 0.1 0.0 2.6 2.7 1.4

Spain 6.0 6.6 222.3 9.6 244.4 222.3

Sweden 0.3 0.4 0.2 86.7 87.5 25.2

UK 4.8 11.5 6.6 164.6 187.5 91.3

Total 136.1 286.3 264.4 1 153.0 1 839.7 1 105.2Memo item:

General governmentdebt outstanding 637.1 1 843.0 638.8 6 852.7 9 971.7

(a) Gross long exposures (net of cash short positions)

(b) Of participating banks in EU stress test only

(c) Includes Norway

Sources: EBA; European Commission; RBA

debt represented about 60 per cent of participating

banks EU sovereign exposures. Their largest foreign

EU sovereign exposures were to Germany and Italy,reflecting the sizeable amount of sovereign debt

these countries have on issue.


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Box B

The Global Reinsurance Industry

Reinsurance is a transaction where an insurer cedes

all or part of an underwriting risk to a reinsurer in

exchange for a premium. By transferring some of

the risks they assume (known as cession), insurers

can reduce risk concentrations and diversify their

risk, which should reduce volatility in their net

underwriting income and leave insurers more

resilient to claims arising from large-scale events

such as natural catastrophes.

Around 200 companies globally offer reinsurance

these firms annual gross reinsurance premiums

written totalled around US$200 billion in 2010, a

small fraction of the US$4 trillion in primary insurance

gross premiums. The global reinsurance industry

is concentrated: the top 10 reinsurers accounted

for nearly 65 per cent of industry gross premiums

in 2010 and the top five reinsurers accounted for

just under one-half (Table B1). Munich Re is the

largest reinsurer in the world with gross premiums

of US$31 billion in 2010, or 15 per cent of the total

market. A number of large general insurers also write

reinsurance business, although most companies

offering reinsurance are specialised reinsurers.

Reinsurers domiciled in Bermuda, Germany,

Switzerland, the United Kingdom and the United

States account for the largest share of the

reinsurance industry. European-domiciled reinsurers

accounted for around 60 per cent of gross premiums

written by the industry in 2010. The US-based

reinsurers made up 15 per cent of gross premiums,

Rank Company Domicile Gross premiums

written

Estimated

market share

US$ billion Per cent

1 Munich Re Germany 31.3 15

2 Swiss Re Switzerland 24.8 12

3 Hannover Re Germany 15.1 7

4 Berkshire Hathaway United States 14.4 7

5 Lloyds United Kingdom 13.0 66 SCOR France 8.9 4

7 Reinsurance Group

of America

United States 7.2 4

8 Allianz Germany 5.7 3

9 Partner Re Bermuda 4.9 2

10 Everest Re Bermuda 4.2 2

Top 10 129.4 64

Total market(a) 203.3

(a) EstimateSources: A.M. Best Company; Swiss Re

Table B1: Top 10 Global ReinsurersRanked by gross reinsurance premiums written in 2010


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while Bermudian reinsurers accounted for 12 per

cent. Despite European reinsurers dominant market

share, the United States is the biggest reinsurancemarket in the world reflecting the substantial value

of insured property in catastrophe-prone areas. By

region of the ceding primary insurer, North America

accounts for the largest share of gross premiums

assumed (about 45 per cent in 2009), while Europes

share is around 30 per cent, and Asias is a little

under one-fifth.

Non-life insurance accounts for the bulk of gross

premiums assumed by reinsurers around four-fifths

in 2009, according to Swiss Re estimates. Primary

insurers cede a higher share of non-life insurance

premiums because many of the potential claims,

such as those resulting from major catastrophes, are

much larger and more clustered than life insurance

claims. Also, some lines of non-life insurance are

more specialised, meaning that primary insurers

that assume these risks can potentially face risk

concentration; ceding a relatively high proportion

of these premiums to reinsurers helps to mitigatethis problem.

Most of the largest reinsurers, such as Munich Re,

Swiss Re, Hannover Re and Lloyds, are highly

diversified across geographical and business

segments. While all of these reinsurers operate

globally, Munich Re and Hannover Re are more

focused on Europe, while Swiss Re and Lloyds

conduct a greater share of their business in the

North American market. Non-life reinsurance

accounts for the bulk of these reinsurers gross

reinsurance premiums, although Munich Re and

Lloyds also have significant primary insurance

operations. Within the non-life segment, these

reinsurers offer reinsurance across property and

casualty lines as well as specialty segments, such

as marine and aviation. Many smaller reinsurers are

domiciled in Bermuda, playing a major role in the

property catastrophe reinsurance market.

The profitability of the large global reinsurers has

generally been solid since the mid 1990s. The

annual after-tax return on equity across seven largereinsurers (the top 10 excluding Allianz, Berkshire

Hathaway and Lloyds) averaged about 10 per cent

between 1995 and 2010, although returns were

low or negative in the early 2000s and in 2008

(Graph B1). Investment earnings accounted for the

majority of reinsurers profits over this period, while

the remainder was mainly due to their underwriting

operations.

Graph B1

1995 1999 2003 2007 2011-5

0

5

10

15

-5

0

5

10

15

Large Global Reinsurers Profits*

US$b %

Profits**(LHS)

* Seven large global reinsurers; excludes Allianz, Berkshire Hathawayand Lloyds due to data availability

** Data for 2011 are for the June 2011 half yearSources: Bloomberg; company annual reports

Return on equity(RHS)

Annualised June 2011half-year result

Profits after tax

Reinsurers investment income, along with that of

many other insurers, declined during the 2008 crisis

as equity prices fell and non-government bond

spreads increased. Investment income has recovered

somewhat since the crisis, although low interest

rates continue to dampen returns. Fixed-income

securities account for around 70 per cent of the

seven large global reinsurers investment portfolios,

while loans and equity investments make up 16 per

cent and 7 per cent, respectively. The proportion of

equities in these reinsurers investment portfolios

has declined by 6 percentage points since the

onset of the financial crisis, while the proportions

in fixed-income securities and loans have increased


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slightly. Large reinsurers generally have significant

investments in sovereign debt, accounting for

around one-half of their fixed-income portfolios inthe cases of Munich Re, Swiss Re and Hannover Re;

the bulk of these exposures are to German, UK and

US sovereign debt. These reinsurers exposures to the

sovereign debt of Greece, Ireland, Italy, Portugal and

Spain are relatively small. Munich Res investments in

Italian and Spanish sovereign debt together account

for 10 per cent of its government bond portfolio,

while Greek, Irish and Portuguese sovereign debt

make up 4 per cent. Swiss Res exposure to these

countries is negligible and Hannover Re also has a

very small exposure.

The recent spate of natural catastrophes has resulted

in most reinsurers reporting an underwriting loss

for their non-life operations in the half year to

June 2011. Aggregate catastrophe claims from the

natural disasters occurring in the first half of 2011 are

estimated to be around US$70 billion, the second

highest (inflation-adjusted) level of claims for any

calendar year since 1970 (see Graph 1.19 in thechapter on The Global Financial Environment).1

Historically, reinsurers underwriting performance

has been significantly affected by catastrophe

events, and the impact of major catastrophes is

evident in reinsurance price cycles. Most notably,

global catastrophe reinsurance premium rates

increased sharply followin

Financial Stability Review - September 2011

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